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New entrepreneurs are often caught off guard by the realities of running a small business. Many aspects of the day-to-day routine are discovered to be much more complicated than the average person would think. Perhaps the best example is merchant services, or the way the business accepts and processes different payment methods.

To your customer, this process seems as simple as putting cash into a drawer or swiping a credit card. They don’t see what goes on behind the scenes. The truth is that every debit or credit transaction involves a series of smaller transactions. Only after these transactions are completed does the business actually get paid for the sale.

What makes merchant services even more confusing is the lack of a single, clear definition.  The term was initially created to describe the services required for accepting credit card payments. Today, however, merchant services can refer to any tool or company involved in the processing of all card-based payment methods. In other words, someone who’s looking for merchant services could be looking for a new company to work with, new software to use, or an entirely new processing system.

In this guide, we’ll go over how merchant services work, the various transactions involved, and the companies and technology that perform them. This will ultimately help you determine which type of merchant services make the most sense for businesses like yours.

What Are Merchant Services?

Generally speaking, merchant services refers to the services and technology involved in the accepting and processing of debit and credit card transactions. To understand how merchant services work, business owners must first learn what goes on behind the scenes whenever a customer makes a debit or credit card payment. Then, they can learn the hardware and software they may need to accept payments, the companies that provide these resources, and the pricing system for merchant services. The key to simplifying merchant services is examining each element, one at a time.

How Do Merchant Services Work?

The merchant services process begins when a customer swipes, inserts or taps a debit or credit card. You or your customer may then have to enter information into a card processing terminal. The hardware and software used for swiping and/or inserting comes from a merchant service provider, or “payment processor.”

The following steps usually take place in a matter of seconds.

First, the payment processor checks with the customer’s bank, which must approve or deny the payment. If the bank approves the payment, the payment processor takes a fee and deposits the remainder into your merchant account. This refers to the separate bank account you’ll have to set up in order to accept debit and credit card payments.

Merchant Services Products

As you can see, the first step of the merchant services process involves the products sold by payment processors. These pieces of software or hardware allow you to accept different forms of payments, i.e. online and in-person.

Here are the tools you’ll need to accept these payment methods:

1. Payment Gateways

Businesses that wish to accept online payments must use payment gateways. This is a piece of software sold by payment processors that essentially takes the place of a credit card terminal.

2. Credit Card Terminals

In order to accept in-person payments, you’ll need a piece of hardware for swiping, inserting, or tapping debit and credit cards. Credit card terminals are directly connected to your payment processor, and they come in numerous shapes and sizes.

3. Point of Sale Systems

Point of sale (POS) systems like PayPal and Square involve both hardware and software. These payment processors provide hardware for accepting payments, as well as software for managing day-to-day sales, tips, commissions, etc. You can even use point of sale systems to accept gift cards, set up loyalty programs, and track inventory.

Since point of sale systems do the same things as traditional payment processors, the term “point of sale system” and “merchant services” are often used interchangeably. You could say that the term “point of sale” was created solely to differentiate companies like PayPal and Square from traditional payment processors.

Merchant Service Providers

Now that we’ve established the tools you’ll need to accept debit and credit card payments, we can move on to the companies that sell these tools, a.k.a. payment processors. You cannot accept debit and credit card payments without the hardware and software sold by payment processors. Much like small business loans, the right payment processor for your business depends on a variety of factors, like your industry, your most common payment method, and the size of your business.

Most payment processors can be categorized as either merchant account providers or payment service providers.  Here are the definitions and primary differences between the two:

Merchant Account Providers

Merchant account providers are the more traditional type of payment processor. Unlike payment service providers, merchant account providers create separate bank accounts for businesses, hence their namesake. This is the account where your revenue from debit and credit card transactions will be deposited. Your provider will help you set up the account and show you how to use it.

Merchant account providers also offer the hardware and software required for accepting payments. They sell POS systems, payment gateways, and credit card terminals.

Since working with merchant account providers involves an entirely new bank account, the application and transition process is significantly longer than payment service providers. Merchant processing rates, however, will likely be lower for merchant account providers.

Payment Service Providers

This is the category that includes popular POS systems like PayPal, Square, and Stripe. Instead of setting up new merchant accounts, payment service providers deposit revenue from debit and credit card transactions into your existing business bank account.

Setting up and using payment service providers is much quicker and less complicated than merchant account providers. Payment service providers also usually have flat rates, regardless of the business’s size or product prices. These rates tend to run higher than merchant account providers. But for many business owners, the ease of using payment service providers greatly outweighs the higher fee. And remember: In addition to basic merchant processing services, you’re also getting software to help manage cash flow.

Price Structures For Merchant Services

You may have noticed an increase in businesses that use POS systems, most notably Square. This is primarily because the pricing system for merchant account providers is notoriously complicated and for many business owners, extremely unfair. Two similar businesses that use the same merchant account provider could have completely different rates. Merchant account providers are also known to lack transparency when it comes to explaining their pricing systems.

POS systems, on the other hand, clearly explain their pricing systems on their websites. But regardless of which merchant processing service you use, your price will depend on the provider, the type of services you need, and how you use them.

Let’s say two companies choose to use Square. One company is a brick and mortar business while the other is purely Ecommerce. Since the first company requires a register-based system for in-person payments, the cost will be significantly different than a company that only needs to process online payments. The difference in cost also stems from the difference in credit card processing fees, which are just a component of the overall cost of merchant processing services.

Though credit card processing fees are displayed as one fee, it’s actually comprised of several fees involving the issuing bank, the credit card provider, the receiving bank, and the payment processor. These four parties are compensated for every debit or credit card transaction you process. The combination of each fee makes up your transaction fee. You will also have to pay recurring flat fees, one-time flat fees, and incidental fees.

In summary, credit card processing fees are made up of transaction fees, flat fees, and incidental fees.

Here are the most common payment structures for merchant processing services:

Tiered Pricing

With tiered pricing, the cost of each transaction is based on the amount of risk involved. Each payment processor has their own tiers, which are associated with different levels of risk. The specific criteria for what’s considered “risky” varies from processor to processor. Most processors, however, use relatively similar criteria. One common example of a high tier transaction is online credit card payments. The cost of this transaction would likely be substantially higher than, say, an in-person debit card payment, due to the lower likelihood of fraud.

For this reason, tiered pricing usually works best for brick and mortar businesses that do not sell online. Other types of businesses would likely find tiered pricing to be the most expensive pricing structure.

Interchange-Plus Pricing

Earlier, we noted that credit card processing fees are made up of several smaller fees, such as the transaction fee. Well, the transaction fee is actually made up of smaller fees as well. Two of these smaller fees are the interchange rate and the assessment fee. The combination of the interchange rate and the assessment fee is known as the interchange fee.

With interchange-plus pricing, your cost is the payment processor’s interchange fee plus a fixed percentage or fee per transaction. In other words, the “plus” part could be a percentage like 20%, or a dollar amount like $0.15.

Some payment processors charge monthly subscription fees on top of the interchange fee and fixed fee per transaction. Others charge a fixed percentage and a fixed fee, instead of one or the other. With both, you’d essentially pay three fees instead of the usual two.

While interchange-plus pricing can get complicated, your monthly statements will clearly state how much you paid for each charge and why you paid that amount. You’ll see exactly how much money went to the payment processor and how much went to the credit card network.

Due to its transparency and lack of risk-based tiers, interchange-plus pricing is widely considered the most desirable pricing structure.

Flat Rate Pricing

Flat rate pricing usually charges a small, fixed percentage of the transaction plus a small, fixed fee per transaction. You’ll pay the same percentage and fee regardless of the type of debit or credit card involved. These rates may differ, however, for in-person and online transactions, depending on the payment processor. Some payment processors even omit the fixed fee, so you’d only pay the fixed percentage of the transaction.

Flat rate plans tend to cost more than interchange-plus but the combination of simplicity and transparency is difficult to pass up. It’s much easier to budget for your total monthly or annual payment processor expense with flat rate pricing. Lots of new businesses use flat rate plans because they don’t have the revenue or time in business to negotiate lower rates with the other two structures. Flat rate plans will also likely be your cheapest option if you sell cheaper products.

One-Time, Recurring and Incidental Fees

The merchant services industry is notorious for hidden fees. Many business owners have made the mistake of believing that hardware, software, and credit card processing fees are the only expenses associated with merchant services. Most payment processors charge numerous additional flat fees, like the aforementioned monthly subscription fee.

Here are the most common one-time, recurring, and incidental fees:

  • Account setup fee: This is a fee for simply opening an account.
  • Account fees: Most payment processors charge a monthly or annual fee for their services.
  • Minimum processing fee: Some processors charge a fee if you don’t meet a threshold for transactions or amount of funds within a certain time frame.
  • Statement fee: Some processors charge a fee to provide financial statements (income statement, profit and loss statement, balance sheet).
  • PCI-compliance fee: This fee covers the credit card company’s cost of ensuring your compliance with industry security standards.
  • Cancellation fee: Some processors charge a hefty fee if you cancel your account prior to the end of your contract.
  • Cardholder dispute fees: This fee is charged whenever a customer disputes a transaction.
  • Chargeback fees: If a customer dispute results in a chargeback, you may face yet another charge on top of the cardholder dispute fee.
  • Withdrawal fee: Some processors charge fees for transferring funds from your merchant accounts to your regular business bank account.
  • NSF fee: A “non-sufficient funds” fee may be charged if your business bank account doesn’t have enough funds to pay your processor.

Disputable Fees

Most legitimate payment processors will omit or not even charge fees for account setup, statements, minimum processing, and cancellation. This last fee can be huge, so make sure to ask about it before signing a contract. You may also be able to negotiate your way out of paying for certain pieces of hardware, whether you are renting or purchasing it.

Regardless of which processor you work with, you should always ask for clarification when it comes to fees. You’d be surprised at the charges you can avoid if you just ask.

What Are The Average Credit Card Processing Fees?

On average, you should probably expect to pay between 1.7% and 3.5% per transaction. This money goes to the issuing bank, receiving bank, credit card network, and your payment processor. Speaking in dollar amounts, the percentage could equate to anywhere from $1 to $5, depending on the price of your products. For example, let’s say your transaction fee is 2%, and a customer spends $50. In this case, you would take home about $49. If your product costed $200, on the other hand, you would take home $196.

As for flat fees, it’s harder to calculate an average because they vary tremendously from processor to processor and business to business. Two businesses that use the same processor could pay very different fees. Monthly account fees can cost as high as $100, whereas incidental fees like cardholder dispute fees and NSF fees are usually much cheaper. But one business could very well have a monthly account fee closer to $10.

Shopping For Merchant Processing Services

Shopping for merchant processing services is a lot like shopping for small business loans. There’s literally hundreds of merchant service providers to choose from. Having so many options can certainly be overwhelming but it also allows you to find the right provider for your specific circumstances.

The key to finding the right provider isn’t spending all of your time examining different options. Instead, you should devote this time to answering a series of questions about your business. This will show you the kind of providers you should look for and compare.

The first question to answer is the nature of your average customer payment. Do you mostly accept in-person payments, online payments, or an even mix of both? Then, consider how your customers make these payments. Do most of them use debit cards, credit cards, or both?

Once you’ve answered these questions, you can look into hardware or software. Do you need a full POS system or just a single credit card terminal? Remember, Ecommerce businesses only need a payment gateway.

Finally, compare the pricing structures of your most sensible options. It’s crucial to pay special attention to fees at this stage. The option with the lowest processing fees may have higher flat fees. In summary, your cheapest option might not be immediately clear.

Merchant Processing Services: Making Your Decision

Businesses that take the time to find the right provider for their needs have a major financial advantage. Credit card processing fees will likely turn out to be one of your most significant annual expenses. Thus, you should prioritize this expense when starting your business and revisit it as your business grows. After all, the nature of your customer payments will likely change in the coming years. For example, it’s not uncommon for a business to change providers when they begin selling product online, or when their online sales catch up with in-person sales.

Different merchant service providers also present their rates and fees in different ways. This is why you should never be afraid to ask for clarification. You’ll probably have to make a few phone calls to get the information you’re looking for. Like every other important expense, you must prepare to devote as much time as necessary to ensuring that you choose the right option. Failing to do so can have dire consequences.

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